During the second calendar quarter of 2013, the Seafarer Overseas Growth and Income Fund declined -4.39% and -4.37% for the Investor and Institutional share classes, respectively. The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, fell -7.95%. By way of broader comparison, the S&P 500 Index rose 2.92%.

The Fund’s two share classes began the quarter with net asset values of $11.70 per share. Near the end of June, both classes paid a semi-annual distribution: $0.14523 per share for the Investor class, and $0.14712 per share for the Institutional class. Those amounts brought the cumulative distributions (measured from the Fund’s inception on February 15, 2012) to $0.25598 per share for the Investor class, and $0.26906 per share for the Institutional class. Both classes finished the quarter with net asset values of $11.04.

Performance

As is obvious from the benchmark’s dismal performance, the emerging markets had a tough quarter. What is perhaps less obvious is how the pain was concentrated in the last five weeks of the period. In fact, the quarter began on a reasonably positive note: between the end of March and the middle of May, the emerging markets were generally stable, and inching higher. Indeed, the Fund’s share price reached an all-time high of $12.27 on May 21^st. The drop since then has been rapid, sharp and painful.

The trigger for the decline was the May 22^nd testimony of Ben Bernanke, Chairman of the U.S. Federal Reserve. In remarks directed at a special committee of the U.S. Congress, Chairman Bernanke suggested that, if the U.S. economy continues to strengthen, and if the country’s unemployment continues to decline, the central bank might gradually curtail its large-scale asset purchase program (otherwise known as “quantitative easing”).¹ Bernanke’s statement was carefully worded, reasonable, and expected by most observers; yet it still sent shockwaves through financial markets around the world, as investors interpreted the comments to mean that interest rates could soon lift off from their current ultra-low levels.

The emerging markets took Bernanke’s comments badly: the emerging markets index plunged -9.70% in dollar terms between his speech and the end of the quarter.² The markets’ verdict was clear; investors were deeply troubled by the mere prospect of higher rates. Yet why was this so? Rates go up, and rates go down. How could a modest increase in U.S. rates undermine the growth story of the developing world?

Bernanke’s words knocked the air out of the emerging world for two reasons. First, growth in corporate revenues and profits has been tepid over the past few years, especially in the larger, so-called “BRIC” markets (Brazil, Russia, India and China). This weak corporate performance has disappointed investors, many of whom harbored high (and misplaced) expectations for the developing world. Investors were thus wary about the outlook for emerging markets; Bernanke’s words only intensified those concerns, as higher interest rates were deemed to be yet another impediment to growth.

Second, emerging market currencies have been in vogue, but their strength has been deceptive. Bernanke’s testimony signaled only a modest change to Fed policy; yet that small shift was still enough to quickly restore the dollar’s status as a reserve currency of choice, and to cause emerging currencies to swoon. As mentioned above, the benchmark index fell -9.70% from the date of Bernanke’s speech to the end of the quarter; 30% of that decline was due to declining currencies, as opposed to falling stock prices.³

I think the retreat of emerging currencies was hastened because their original embrace was based on a false premise. For the past three years or so, investors have worried the Fed’s unorthodox monetary policies might debase the dollar (a legitimate, if exaggerated concern). That fear manifested itself in a natural desire to seek currencies that could serve as an alternate haven for capital. Unfortunately, investors employed faulty logic in their search: they assumed the dollar’s defects (lax monetary and fiscal policies), when inverted, would define other currencies’ strengths. Some commentators fueled this assumption by heralding the “solid fundamentals” and the “pristine balance sheets” of the developing world, implying debt from that part of the world might serve as an antidote to the dollar’s woes.⁴ Thus began the heady ascent of emerging currencies.

Certainly, I think the developing world benefits from certain economic and financial advantages, or “strong fundamentals.” However, those benefits accrue slowly, over long periods of time. The difficulty for investors is that such long-term benefits do not confer short-term financial strength. In other words, “good fundamentals” are no substitute for the depth, on-demand liquidity and stability that the dollar affords. Emerging currencies have made great strides over the past decade; but it will be one or two more decades – if ever – before any could act as a meaningful surrogate for the dollar.

Amid this challenging environment, the Fund outperformed its benchmark; but otherwise its performance was disappointing. Latin America was by far the Fund’s weakest spot: the region accounted for roughly 75% of the Fund’s losses during the quarter. Within that region, the losses were heavily concentrated in just two holdings, both of which are classified within the commodity sector: SQM (a Chilean mining company) and Vale (a Brazilian iron ore producer). Those two positions accounted for a bit over 50% of Latin America’s losses within the portfolio (or 40% of the Fund’s total losses).

Obviously, I am frustrated with the performance of these two holdings. Historically, I have avoided investments in commodities: the stocks are so very volatile, and valuations are quixotic, swinging wildly with sentiments regarding the health of the global business cycle. Yet these two positions were attractive enough to overcome my reservations. They stood out because of the quality of their businesses, the strength of their cash flow, and the safety of their balance sheets. Before I added the two positions to the Fund, the Seafarer team did ample work to test their valuations. I was convinced the stock prices were sufficiently attractive (low) that the Fund would likely be insulated from severe capriciousness in markets. In hindsight, I was wrong, and my timing was poor – at least in the short run. The experience has been a painful one, and it has reminded me why I generally avoid the sector.

Nonetheless, I remain confident in our analysis: our work stress-tested each company’s cash flow and valuation in preparation for difficult conditions such as the present. Following the sharp decline in their prices, I believe both stocks offer improved potential for risk-adjusted returns. As such, I intend to remain invested; however, as a measure of risk control, I intend to limit the Fund’s exposure to these two stocks to roughly 7% of net assets (unless the stocks surpass that threshold due to appreciation). Nor will I seek to add additional exposure to commodities above and beyond these two holdings. For reference, the two stocks comprised about 6% of the Fund at the end of June.

There was one substantial bright spot: the Fund’s holdings in Asia gained slightly during the quarter, even as the benchmark index for the Asian region fell approximately 5%.⁵ This outperformance was due to two primary causes. First, the Fund's holdings in Asia health care stocks performed exceptionally well, notably Hartelega (a surgical glove maker based in Malaysia), and Shandong Weigao (a medical equipment producer from eastern China). Second, the Fund’s new holdings in Vietnam made a welcome contribution. Vietnam’s stock markets have performed well this year, in recognition of forthcoming economic reforms, and because valuations on many Vietnam stocks are not demanding.

Allocation

I think it is an interesting time to be an investor in the emerging markets.

Even before Bernanke’s testimony in May, valuations on some emerging markets stocks were reasonable. Since that time, most valuations have become downright accommodating. Also, the frothiness that characterized many emerging currencies has dissipated. Most importantly, the hype that has surrounded the emerging markets during the past six or seven years has dwindled – the best evidence of which is the number of prominent investment banks that have tripped over themselves to downgrade the developing world (most all were champions of the emerging markets not long ago).⁶

Obviously, the immediate outlook is challenging, and plenty can go wrong from here. Growth is tepid; there are riots in Brazil, Turkey and Egypt; India’s fiscal woes have sent its currency into a tailspin; and China’s economy appears vulnerable to recession. Still, valuations are now low enough to compensate for some of these risks. I don’t know when the markets will bottom. However, my experience suggests that present conditions usually provide attractive opportunities to patient, disciplined long-term investors.

In my view, one of the most interesting ideas for long-term investors to contemplate right now is the BRIC markets (Brazil, Russia, India and China). These four economies are the largest among the emerging markets; their relative size and growth made them darlings of Wall Street for the past ten years or so. However, their performance in the last five years has been dismal: if you were a dedicated investor in the emerging markets, the best thing you could have done with your portfolio is invest nearly anywhere else. Brokers and fund managers have heavily promoted these four markets as a key “theme” for investors to follow – thus the four markets even have their own catchy acronym, “BRIC.” Unfortunately, the BRICs peaked versus the rest of emerging markets in the summer of 2008; sadly, but not surprisingly, that peak was not long after the surge of new BRIC-based products, all of which were meant to capitalize on investors’ desire to track the theme.

I avoid broad-based themes when investing: by the time a given theme is “recognized,” packaged neatly and marketed, it is almost always too late – the underlying asset is near its peak. However, sometimes a theme can fall so far out of favor that it becomes interesting again – and so it is with the BRICs. The four markets have underperformed to such an extent that their aggregate valuation, when compared to the emerging markets as a whole, is as low as it has been in eight years. In other words, based on a variety of valuation metrics (price-to-book value, price-to-prospective-earnings and dividend yield), the BRICs are as cheap relative to the rest of the emerging markets as they have been in a long time. I find this interesting. I cannot “call a bottom” in these four markets – but I can’t help but think that, just as dedicated investors in the emerging markets did well to shun the BRICs over the past five years, investors will do to embrace them over the next decade.

Among the BRICs, I am intrigued by Brazil. At the Fund’s inception, its exposure to that market was limited, especially relative to the benchmark index. I was worried about the valuations of Brazilian stocks and the local currency (the real), but both have plummeted in the past year. The Fund’s exposure to that country has recently grown with the addition of a new holding (a specialized commercial printer), and it may grow further in the coming quarters.

Brazilian financial markets have retreated for many reasons, especially concerns about the Rousseff administration’s meddling in the economy, and because of recent street protests there. While I can understand such concerns, I find them a bit ironic. Throughout my career, the constant complaint among investors in the developing world is that various countries avoid “taking the tough medicine,” and defer economic reforms. I read many complaints about Brazil these days, but this is not one of them! Rousseff has not been shy about pursuing regulation and reform, and her vigor has cowed the market. I don’t endorse all that her administration has done, but I am happy to see Brazil undertake some painful but necessary changes. I think that on balance the Brazilian economy will be better for it over the next decade.

The recent demonstrations in Brazil speak to the frustration and disaffection felt by a substantial portion of the society. To date, most of the country’s protests have been peaceful; but on one major occasion (June 21^st), they disintegrated into riots, as violence and chaos filled the streets of Rio and São Paulo. I don’t dismiss the gravity of such events, but I think it is important to take stock of the protesters’ main grievances. They are upset over the pace of growth, their share of the gains, government corruption, and the paucity of public transport systems. Notably absent from the demands are staples such as homes, food and jobs. It seems to me that for the most part, the demonstrations bear witness to the emergence of a new middle class: a large and vocal portion of society is asserting its political will; and it is demanding change and reform as opposed to basic necessities.

Some financial strategists promote the “emerging market consumer” as a key investment theme. They discuss the middle class as if it was a tidy little commodity you could bank on – a parcel of consumers that will buy toaster ovens, refrigerators and beers, and then curl up happily into their brand new beds. Obviously, the real world is far, far messier. Brazil’s new middle class has found a political voice, and it has chosen to assert itself in an uncomfortable manner. The clear danger is that legitimate grievances are manifested in violence and chaos. Yet if Brazil can find the political will to resolve the protesters’ demands peacefully, via reform and under the rule of law, the country will be better for it. Turkey is experiencing something similar, and one day, China may too. As far as I can tell, we are witnessing the difficult but transformative birth of a middle class – and I plan to invest in it.

The performance data quoted represents past performance and does not guarantee future results. Future returns may be lower or higher. The investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than the original cost. View the Fund’s most recent month-end performance.

The MSCI Emerging Markets Total Return Index, Standard (Large+Mid Cap) Core, Gross (dividends reinvested), USD is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Total Return Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. Index code: GDUEEGF. It is not possible to invest directly in this or any index.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

As of 4/30/2013, SQM (Sociedad Quimica y Minera de Chile SA ADR) comprised 3.0% of the Seafarer Overseas Growth and Income Fund; Vale (Cia Vale do Rio Doce, Pfd.) comprised 1.9% of the Fund; Hartalega Holdings Bhd comprised 2.4% of the Fund; and Shandong Weigao Group Medical Polymer Co., Ltd. comprised 2.2% of the Fund. View the Seafarer Overseas Growth and Income Fund’s Top 10 Holdings. Holdings are subject to change.

1. Ben Bernanke, “The Economic Outlook,” Testimony Before the Joint Economic Committee, U.S. Congress, 22 May 2013.
2. Note: based on the performance of the MSCI Daily Total Return Gross Emerging Markets Dollar index (ticker: GDUEEGF) between May 22 and June 28, 2013.
3. Note: “fell -9.70%” based on the performance of the MSCI Daily Total Return Gross Emerging Markets Dollar index (ticker: GDUEEGF) between May 22 and June 28, 2013. “30% of that decline” based on performance of MSCI Daily Total Return Gross Emerging Markets Local Index (ticker: GDLEEGF), which declined -6.76% between May 22 and June 28, 2013. Sources: MSCI, Bloomberg and Seafarer.
4. PIMCO, “The Caine Mutiny (Part 2),” 1 May 2011; and Franklin Templeton, “Franklin Templeton Investments Introduces Templeton Emerging Markets Bond Fund for U.S. Investors,” 3 April 2013.
5. MSCI Total Return Gross AC Asia ex Japan index (ticker GDUECAXJ). Sources: MSCI, Bloomberg and Seafarer.
6. Bloomberg News, “Emerging Markets Era of Outperformance Is Ending, Goldman Says,” 20 June 2013, and “Ruble to Real Roiled as No Brick in BRICs $13.9 Billion Lost,” 10 July 2013.